The central bank of a country can adopt an expansionary or contractionary monetary policy. An expansionary monetary policy is focused on expanding, or increasing, the money supply in an economy. On the other hand, a contractionary monetary policy is focused on decreasing the money supply in the economy. The central bank uses its monetary policy tools to increase or decrease the money supply.
So, how does one determine whether a monetary policy is expansionary or contractionary? To do so, we need to understand the economy’s real trend rate and the neutral interest rates.
The real trend rate, also called just the trend rate, is the long-term sustainable real growth rate for an economy. This is the rate an economy can maintain without inflationary pressures. This rate is not directly observed and needs to be estimated. The rate also changes as the economic conditions change. For example, if an economy was consumption oriented backed by debt for a few years, and then the focus shifts towards reducing debt and increasing savings, the trend rate will reduce.
The neutral interest rate is the growth rate at which the growth rate of the money supply remains constant. This implies that the real GDP is growing at the trend rate and the inflation is stable.
We can compare the discount rate (policy rate) with the neutral interest rate. If the discount rate is above the neutral interest rate, we can say that the monetary policy is contractionary, and vice verse. This means that the central bank is trying the decrease the money supply.
The adjustment to monetary policy usually reflects the source of inflation. If the inflation is above target because of increase in aggregate demand, contractionary policy is suitable. However, if inflation is high because of supply shocks, then a contractionary monetary policy is not suitable.